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Interview on the Lithuania Currency Board System

Briefly, what is the history of Currency Board in the world? Has it generally been successful or unsuccessful model of running monetary policy? In unsuccessful cases, what has been the main cause of the failure? How would you compare Currency Board to other models that restrict (diminish) the role of monetary authority?

The first currency boards were established in the 19th century. Currency boards became widespread in the first half of the 20th century. They were especially common in British colonies, where they provided a simple an effective way of ensuring that local currencies maintained value against the pound sterling. Currency boards also existed in a number of independent countries. They had an excellent record of avoiding depreciation and maintaining full convertibility in their anchor currencies. Compared to countries that had central banks, inflation was low and economic growth was equally satisfactory.

Currency boards fell out of favor after about 1950 because economists and policymakers thought discretionary monetary policy practiced by central banks would promote faster economic growth. The imagined advantages of central banking, rather than any actual defects of currency boards, were responsible for most countries replacing their currency boards with central banks. The results were often quite poor. Countries such as Burma, Jamaica, Nigeria, the Philippines, and Zimbabwe experienced high inflation and relative economic decline under central banking.

With the collapse of communism, interest in currency boards revived because of the simplicity, effectiveness, and good historical record of currency boards. Estonia, Lithuania, Bosnia, and Bulgaria all established currency board-like systems from 1992 to 1997. Argentina established such a system in 1991, inspired in part by an earlier experience with a currency board before World War I. These currency board-like systems contain certain loopholes that were absent from most earlier currency boards. In Argentina’s case, the loopholes contributed to the spectacular collapse of the system and the Argentine economy in 2001 and 2002. I have written about the Argentine case at length elsewhere—most recently in an article published in the February 2008 issue of the Central Banking Journal. It was aptly titled “Why Argentina did not have a currency board.”

There are other systems besides the currency board that restrain discretionary monetary policy. The most widespread historically are dollarization (which exists in some countries today) and free banking (today extinct but still possible). These systems all have in common the lack of a domestic central bank issuing a national currency. The euro also achieves this, in a different way from the other systems. What they all have in common is that they have avoided episodes of high inflation.

On the 1st of April it is going to be 15th anniversary of currency board in Lithuania. Do you remember the situation of Lithuania’s economy 15 years ago, when the model of Currency Board was being implemented? What impact had the Currency Board on Lithuania’s economy?

Thanks to the good work of the Lithuanian Free Market Institute, Lithuania was the first country in the former Soviet Union where a currency board was widely discussed among the public and government officials. The currency board became front and center after Prime Minister Adolfas Šleževičius visited Estonia in 1993. He was impressed by Estonia’s currency board and inquired as to who designed Estonia’s system. As a result, he contacted me in Paris and invited Mrs. Hanke and me for a private lunch in Vilnius on January 26, 1994. Before the dessert was served, the Prime Minister decided that Lithuania would install a currency board and that I would serve as State Counselor. This rapid decision was based, in part, on the impressive performance of Estonia’s currency board. In addition, the Prime Minister Šleževičius was convinced that a rule-based currency board would put the Bank of Lithuania on a short leash and that it would also impose a hard budget constraint on the parliament.

Lithuania could have been the first to establish a currency board and to immediately establish a credible currency. Instead, it waited almost two years after Estonia, in the meantime making slow progress in monetary policy and in economic policy generally. The Law on Litas Credibility accelerated progress by putting the currency on a firmer basis and provided a level of reliability that few other currencies in Central and Eastern Europe have matched.

What are the main lessons from Lithuanian Currency Board? Did your theoretical expectations come true?

As expected from historical experience, inflation fell to single digits, the exchange rate remained stable, and full convertibility was possible. Moreover, these conditions have persisted. The link to the euro has helped Lithuania become more closely integrated economically with Western Europe.

Would Lithuanian economy look differently today, if currency board was not implemented 15 years ago? How different would it be?

Lithuania might have been like Latvia. Latvia experimented with a floating exchange rate for a while, then with a peg to a basket of currencies, until finally pegging to the euro years after Lithuania. Until recently, Latvia claimed that its central bank operated like a currency board, but the system had no legal foundation like the Law on Litas Credibility. When Latvia experienced trouble last autumn, the Bank of Latvia reduced its foreign reserves below 100 percent of the monetary base as part of the rescue of Parex Bank. There was fear of a devaluation and Latvia’s government had to ask the IMF and other sources for loans that are quite large in relation to the size of the economy.

There aren’t many countries in the world that have currency board. Why do you think that is? Would the situation change with the crisis? Is a fiat currency a good anchor for a Currency Board? What other solutions do you see in the future? Is it gold, gold standard, 100% bank reserves, or what? What are the economic advantages and disadvantages of each model?

As I mentioned above, currency boards were out of fashion for a long time, not because of their defects, but because of the imagined advantages of central banking. Many countries would have better economic records if they had currency boards rather than national central banks, but politicians typically dislike the limits on their actions that a currency board imposes. To me, the ideal system is one of full currency competition, where people are free to make contracts in any currency they wish and financial institutions are free to experiment with offering any unit of account they think the public might accept. Monetary needs evolve over time, and competition allows institutions to evolve with them.

Does current economic crisis in the world have anything to say about the model of Currency Board? How does Currency Board model work and how does it survive during economic crises? What are other processes in the economy with the Currency Board during the recession?

No monetary system can insulate an economy from all problems that may arise. The world economy is shrinking, and few countries will grow this year. It is noteworthy, however, that the first wave of countries to experience severe currency problems have been those with central banks — within Europe, Iceland, Ukraine, Latvia, Hungary, and Belarus.

If speculative pressure on the litas increases, Lithuania has the option of euroizing, like Montenegro did in 1999, when I was former President Milo Djukanovic’s advisor. The experience of Slovakia, which recently became a member of the European Central Bank, and of Montenegro, which is not a member of the European Central Bank, shows that the euro provides monetary stability. The barriers that the European Union has raised to euroization are illogical and especially counterproductive during the current financial crisis.

What are the benefits and disadvantages from the Currency Board for the Lithuania’s economy today? What is your advice to Lithuanian authorities, if they wish to sustain the Currency Board?

At present, all countries are experiencing the pain of a world economic crisis. In Lithuania, the pain is mitigated by the currency board system. In short, things would even be worse if Lithuania had any other type of exchange-rate regime—short of being a member of the European Monetary Union. That brings me to the ill-conceived decisions by the EU Commission and the ECB in 2006—namely to prohibit Lithuania from joining the EMU. The costs of those bad decisions in 2006, for both the EMU member states and Lithuania, can now be counted.

Mainstream economists look at the deflation (which is sometimes inevitable in countries with Currency Boards due to contraction of money supply) with fear. How would you comment on that? Should people be afraid of deflation? Are deflationary processes harmful for the economy?

The mainstream view is incorrect. Currency board systems have not been prone to sustained bouts of deflation. This validates my “95% rule”: 95% of what is published or broadcast about economics and finance is either wrong or irrelevant.